What China’s Surprise Announcement Means for the Oil Sector

Special Report from Money Morning

by Kent Moors, Money Morning

The People’s Bank of China just cut the value of the yuan 3%.

The announcement took analysts by surprise and signaled that Beijing has decided to shore up a weakness in exports. This will usher in similar moves by other Asian countries that are export competitors.

For the U.S. oil sector, it means another painful period of time.

Technically, the PBOC move amounted to a change in the way the central bank calculated the value of the yuan against the U.S. dollar by revising the way in which the daily midpoint is determined. Now it will result from market makers’ quotes and the previous day’s closing price.

The result was a 2% decline in the yuan’s exchange value and the largest one-day drop in the currency’s value against the dollar ever recorded. The previous record was a less than 1% decline in December 2008, the intense period in the global credit crunch. The yuan’s exchange value is now at a level last seen three years ago.

Here’s what this means for the price of oil…

Why a Cheaper Yuan Is Putting Pressure on Oil Prices

Making one’s currency cheaper against major outside trading currencies effectively reduces the price of exported goods since they are now produced by cheaper domestic payments that allow outsiders using hard currency to reduce their payments for what is produced.

More broadly for oil, this is seen as a sign of further weakening in Chinese industrial demand for energy. That prognosis may be a bit premature (since there will be no figures to sustain a judgment either way for at least three months), but nonetheless it will feed into the current market’s penchant for overreacting emotionally to each new development.

Coming on the heels of major declines on Chinese stock exchanges, pundits will now bang the drums for a Chinese-led restraint on oil prices.

Yet all this means just one thing for Chinese authorities…

That’s that they’ve actually lowered artificial manipulation practices with the nation’s currency, moving closer to allowing the foreign exchange market to determine the actual value of the yuan.

The direct connection between Chinese exports and energy needs has always been a debatable issue. There is no doubt that industry in general is a heavy user of imported oil, and a decline in production for export would have an impact on oil imports into China.

However, it is the rising domestic market that will be fueling the brunt of oil needs moving forward. It is here that the perceived decline in domestic economic expansion looms.

Why a Chinese Slowdown Isn’t Bad News for Energy Markets

Yet even here the pundits are overreacting. A continued Chinese 7% annualized expansion rate is neither realistic nor desirable. The dislocation and inflationary pressures incumbent on such an overheated environment are counterproductive. As long as there had been domestic slack to absorb the expansionary pressures, it could be discounted.

But these days, moving the expansion “down” to around 5% provides greater stability – for both the rapidly accelerating Chinese middle class and the more market-oriented currency.

Nonetheless, expect the ripples from last evening’s yuan devaluation to be the topic of hotly contested conversation on commodity prices over the next few days.

How the Rising Cost of Debt Is Hurting U.S. Oil Producers

The more serious effect on the American oil and gas-producing sector will be coming from further deterioration in the energy debt market.

Most U.S. producers have been “cash poor” for much of the past decade. That refers to their operations costing more than the proceeds of production.

In normal pricing environments for oil and gas, this does not mean very much. Debt could easily be rolled forward to cover capital expenditures, while cash in hand could be reserved for benefits to shareholders (dividends, share buyback programs, etc.).

However, today the situation is very different. Energy debt comprises the highest stratum of what is termed “high-yield debt.” This is not investment grade and is usually referred to as “junk bonds.” The yields are higher because the risk is worsening.

Here’s the rising problem in a nutshell.

The spread between investment grade and junk bonds has been widening, with an additional premium being required for the highest risk associated with energy. Today, new rollover bonds are requiring annualized interest payments of almost 14%. That rate will increase as we move into the third quarter.

In addition, banks will be restructuring debt portfolios by October and again toward the end of the first quarter in 2016. On both occasions, energy debt will become even more expensive.

A return to $70 a barrel oil prices and $4 per 1,000 cubic feet for natural gas would change the picture considerably. But neither is likely until the end of this year or into 2016. The debt picture will be getting worse before it evens out.

And that means the cycle of smaller company liquidations and broader M&A activity will intensify.

That’s bad news for some vulnerable companies but good news for us.

There will be a fire sale involving choice wells, drilling locations, and leases.

And we will have some nice pickings in an exceptionally oversold sector. I’ll keep you posted.